In a new white paper, Larry Tabb, namesake and CEO of the Tabb Group, dives into the payment for order flow issue and draws a nuanced conclusion. While payment for order flow may create distortions, and even “artificial ripples” in the price discovery, sending orders to buy and sell stock to venues that may not have the best execution history, upsetting the standard quo may bring unintended consequences as well.
Larry Tabb notes ICE derivatives CEO wanted payment for order flow banned
In the white paper titled “Rebates and Market Distortions: The Cost of Liquidity?” Tabb Group, a capital markets research and Wall Street market structure analysis, notes that Jeffrey Sprecher, CEO of the ICE derivatives exchange, which recently purchased the NYSE Euronext (NYSE:NYX), has wanted payment for order flow banned. The NYSE has suffered a slide in trading volume as the once dominate exchange fights off competition from alternative trading venues such as dark pools.
As noted in ValueWalk, TD Ameritrade Holding Corp. (NYSE:AMTD) was questioned in a US Senate hearing regarding sending the vast majority of its stock orders to venues other than the NYSE, but rather to an exchange that paid the highest rebate fees. Tabb wants to take the issue further.
“Just discussing rebates and maker / taker pricing is interesting but it misses the broader picture of pricing distortions or non-transparent payment mechanisms that create artificial ripples in the price discovery process,” he writes in the report. “These mechanisms attract flow to venues where it may not necessarily belong and may not have the best execution history.”
Tabb: Notorious distortion has other more than one culprit
In the report Tabb says that “while rebate pricing schemes are the most notorious distortion” in the price discovery process, there are other culprits. These include exchange pricing tiers, the development of internalization and ATS platforms, payment for order flow relationships where wholesalers buy order flow from retail brokers, soft-dollar relationships where commission dollars are used to pay for brokerage services, typically including trading tools, research, and corporate access.
“Our markets are not distortion-free,” Tabb says. “Liquidity and its immediacy have a price and a value.” That value, Tabb surmises, is extracted from various strategies employed by automated trading systems and soft dollar transactions. In other words, those low commissions investors pay through firms such as TD Ameritrade Holding Corp. (NYSE:AMTD), Interactive Brokers Group, Inc. (NASDAQ:IBKR) or Charles Schwab Corp (NYSE:SCHW) is really being subsidized by these undisclosed payments between brokerage firms and the exchange trading venue.
Larry Tabb on the complexity in the market structure
Tabb tackles the issue of complexity in the market structure, making the point that simplicity should not be in a vacuum. “Incentive programs while complex, benefit many,” Tabb says. “The question is, should simplifying complexity for complexity’s sake be our goal, especially since most of this complexity is abstracted away by fast computers, smart order routers, and high speed networking?”
In his conclusion, Tabb assumesbecause the NYSE is pushing to eliminate rebates, it benefits from a simplified execution fabric, then asks “would that be good for all exchanges? Probably not. Less flow to dark pools would be good for exchanges while lower take fees would be good for brokers and possibly investors. Conversely, lower rebates would hurt liquidity providers, widen spreads and possibly turn fast liquidity providers into liquidity takers, thus making the markets more volatile.”
Complexity is one issue. Legality is another. In yesterdays Congressional testimony we learned Vanguard Group essentially turned down what would likely be nearly $200 million in payment for order flow deals from exchanges because they didn’t think such arrangements were legal. In this report, Tabb did not speculate in regards to that hot potato. But in regards to payment for order flow, if stock investors are unhappy, “change should just be a click away.”